Finance ministers to avoid ECB clash over rate rise

Eurozone finance ministers are expected to play down their dispute with the European Central Bank (ECB) when they meet next week (5 December), even though Jean-Claude Juncker, the chairman of eurozone finance ministers’ meetings, has again questioned the ECB’s monetary policy.

Two days before the ECB was expected to raise its key short-term interest rate, Juncker told the economic and monetary affairs committee of the European Parliament on Tuesday (29 November): "We feel that the outlook for inflation is not worrying enough for [the ECB] to give rise to this sort of action."

Jean-Claude Trichet, the president of the ECB, has signalled that the bank will increase its key short-term interest rate at its governing council meeting on 1 December.

His decision to "pre-announce" an interest rate increase has been seen by some ECB watchers as a sign that the central bank is divided over whether to raise rates from the historically low level of 2% which has prevailed for the past two and a half years.

Juncker's comment will raise the same question about unity among eurozone finance ministers.

While there is a strong feeling that the ECB may be moving sooner than it needs to, given the still uncertain strength of the eurozone economy, there has been little open public criticism from finance ministers. In part this reflects a fear that attacking the ECB will only make it more obdurate. But there is also a recognition that at some point, assuming the economic recovery continues, rates will have to rise and that it is unwise to trigger a confrontation over a small move which is unlikely to do any serious damage.

That view was endorsed this week by the OECD, which said in its semi-annual economic outlook: "The case for a prolonged world expansion extending to convalescent European economies looks plausible.

"An isolated rise in [interest] rates would not by itself have much effect."

The ECB is however in a difficult position. It is worried that the extended period of historically low short term interest rates, lower than inflation, is producing potentially damaging distortions in the EU economy, in particular rapid credit growth and increases in asset prices, especially house prices.

The ECB is also worried that the global economy is awash with liquidity and that exceptionally low eurozone interest rates are adding to this and distorting the values of assets on international financial markets. However, such concerns lie beyond its legal remit, which was designed before international financial market integration had progressed as far as it has today.

The ECB is aware however that moving rates up now is politically - if not economically - a high-risk strategy. In the past three years there have been two aborted economic recoveries in the eurozone and were the nascent recovery to peter out next year, the ECB would be blamed. As Juncker told the Parliament, finance ministers do not feel that their worst fears about inflation have been realised. Wage increases have been characterised by a degree of stability that is "rather surprising". "Underlying inflation is developing in a manner which we consider to be restrained," he added.

The EU must prepare now for the possible crash in the value of the dollar which could accompany the inevitable correction of global economic imbalances and a sharp reduction in the US' $759 billion current account deficit. This is the conclusion of a study for the think-tank Bruegel by two economists, Juergen von Hagen of the University of Bonn and Alan Ahearne, a Bruegel Research Fellow.

Although the ECB does not need to act now, it "should stand ready to loosen monetary policy promptly and aggressively should a sharp adjustment occur that threatens to result in deflationary pressures", the report says.

But EU states must get their budgets into balance or small surplus, so that they have room to use increased government spending "to mitigate the decline in aggregate demand resulting from the US current account adjustment", it adds.

In order to shrink the US current account deficit a real decline in the value of the dollar of 30% over the next three years is required, the paper says. This would knock around $300bn off the value of dollar assets owned by European investors. A disorderly slump in the dollar, an abrupt collapse, would be much worse, spilling over and dragging down asset prices in Europe and hitting the EU economy.

Reducing the US trade deficit will also involve a sharp reduction in Europe's exports to America, the main engine of EU growth in the past three years.